Modelling Fire Sale Contagion Across Banks and Non-banks

Abstract

We study the impact of common asset holdings across different financial sectors on financial stability. In particular, we model indirect contagion via fire sales across UK banks and non-banks. Fire sales are triggered by different responses to a financial shock: banks and non unit-linked insurers are subject to regulatory constraints, while funds and unit-linked insurers are obliged to meet investor redemptions. We use our model to conduct a systemic stress simulation under different initial shock scenarios and institutions’ selling strategies. We find that performing a stress simulation that does not account for common asset holdings across multiple sectors can severely underestimate the fire sale losses in the financial system.We also show that a pro-rata liquidation strategy would result in a higher level of fire sale losses, but a waterfall strategy may produce a higher spill over effect for a passive institution (or a passive sector) that chooses not to liquidate any of its assets during distress.